Question

A company has funded 10 percent fixed-rate assets with variable-rate liabilities at LIBOR + 2 percent. A bank has funded variable-rate assets with fixed-rate liabilities at 6 percent. The bank's variable-rate assets earn LIBOR + 1 percent. The company and the bank have reached agreement on an interest-rate swap with the fixed-rate swap payment at 6 percent and the variable-rate swap payment at LIBOR. Briefly discuss your results.

What will be the net after-swap yield on assets for the bank?

Answer 1

Interest Rate Swap involves swapping of fixed interest rate payments with floating rate payments centered on a benchmark which is generally LIBOR while no exchange of cash flows is made at initiation. One party in a swap received fixed rate payments and the other party receives floating rate payments based on LIBOR. Interest rate swaps are entered by a party which has fixed rate and floating rate exposure.

The party which has floating rate exposure such as the variable rate liabilities is afraid of interest rate rising, it enters the swap as floating rate receiver. The other party which has fixed rate exposure in the form of fixed rate liabilities is afraid of floating rate falling, hence it enters the swap as fixed rate receiver.

In this case, the bank has fixed rate liabilities and floating rate assets, if the interest rate in the market falls, the bank will lose on both fronts. Hence, in order to hedge itself, the bank will initiate a swap contract with counterparty. The mechanism of swap can be understood with the help of the following diagram:

LIBOR Income from Assets @ LIBOR +1% COMPANY BANK Fixed Rate Payment @ 6% Liabilities Payment @6%

Hence, the Bank is receiving LIBOR + 1% from its variable rate assets, and the bank is paying LIBOR to the company as a part of swap entered. Hence, on the net basis the bank is earning 1%.

On the other hand, the bank is getting 6% from the company as a part of swap and fixed rate liabilities are met with that 6%. Hence, on the liabilities front, there is no profit, no loss.

Hence, net after swap yield on the assets for bank is 1%.